Most people are not that good at predicting the future of the economy and the stock market, but there are quite a few pretty talented people who are. Most importantly, they are willing to bet their money (and a whole lot of it) on their vision of the future, instead of just yapping about it on television with no real consequences to themselves (think Ben Stein or Jim Cramer). These people are hedge fund managers, especially those who follow directional global economy based strategies.

Hedge funds are run by smart guys. They strive to generate attractive risk-and-return patterns for their investors through a wide variety of investment strategies. Broadly speaking, these strategies could be classified as “search for alpha” (e.g. “equity market neutral”) and “bets on beta” (e.g. “global macro”). Alpha strategies aim at generating returns patterns that are not related to the market or any known economic risk factors. Beta active strategies, on the other hand, generate returns by taking positions driven by underlying economic factors. The best beta active hedge fund managers are pretty good as a group in anticipating which of the economic factors would deliver superior performance in the future. If we could only see these positions, we would’ve been able to peek into the future (as perceived by a group of really smart hedge fund managers)…

It is commonly accepted that “true” economic growth is the growth driven by technological innovation, and it is roughly approximated by a country’s GDP per capita growth. However, as I argued in an earlier post, short-term economic growth numbers could be distorted by monetary and fiscal policy choices. For example, a government may boost short-term GDP numbers by borrowing money through the sale of its long-term debt (say, twenty year bonds). By doing so, it employs the fundamental “time machine” feature of finance, which allows for the exchange of an uncertain future payoff for a certain payoff today. Ultimately, the repayment of the long-term government debt would be driven by the overall economy twenty years from now, i.e. people working, producing, consuming, and paying taxes then. Some of these people may not even be born today – how can we know for sure the number of workers and how productive they will be twenty years from now?

You need money to make money, right? The same 10% return looks and feels very different for a one million dollar investment vs. a one billion dollar investment. Not surprisingly, the competition in the asset management industry for investors’ assets is fierce – there is a lot at stake. How does one convince a potential client to invest in your investment vehicle? Keep in mind that the investment would be made on an implicit promise of future performance, which, by the way, will only materialize after the investment decision is made. Even then, it may require several years of data to truly assess its performance. How do you convince a wary client that the future is bright and that his/her money will be well taken care of? Are you truly sure that the performance of your strategy a few years down the road will meet the needs of the client? Most importantly, how do you differentiate your investment vehicle from others who could be making outlandish claims about their funds’ expected future performance?

As I look across the hedge fund universe, 90% of what I see is not “picking assets to exploit information not reflected in prices,” it is “taking exposure to factors that managers understand and can trade better than clients.”

Quite a few years ago, back in 2008, I had the following conversation with one of my MBA students, Billy Ruck:

Billy: Why aren’t ETFs more popular now? They are great…

Alexey: Yes, ETFs are great! It’s a conspiracy, man!

As outlandish as my response may have seemed, it was absolutely true. Since this interaction, it’s been fascinating to see how both parts, the ETFs and the conspiracy, have been playing out. But, before we break out the tin foil hats, let me expand a bit on my 2008 answer…

Smart beta – another hot term these days… It has a nice familiar ring to it, as it sounds like an incremental improvement over the good old CAPM beta! There is something harmless and comforting in the name “smart beta”, especially after the past horrors of exotic derivatives and credit default swaps.

The brilliance of the marketing behind smart beta is akin to the “easy” button at Staples – it makes you think that there is a magic shortcut to solving the challenges of modern investing, almost as simple as pressing the easy button.Unfortunately, the realities behind the easy button and smart beta investing are not simple at all. Instead of the easy button at Staples there are mind numbing choices of stationery and office products. Similarly, smart beta stands for hundreds, if not thousands, of funds that provide exposure to a multitude of risk factors, either in pure form or bundled with other risk exposures.

The true beauty of smart beta is in its very complexity, as it offers an opportunity for the extremely granular approach of fine-tuning your investment strategies across a multitude of risk dimensions based on your individual objectives. Navigating the smart beta world requires an understanding of all of the options, and it is ultimately your responsibility to pick the exact smart beta products that work specifically for you. And that isn’t easy at all, smart beta or not!

Alternative investments are hot these days… But what are they, exactly? Broadly speaking, “alternative investments” could mean pretty much anything beyond “traditional” investments in stocks, bonds, or cash. These could be futures, options, commodities, currency carry trades, and a multitude of other specific strategies that yield risk-and-return profiles that don’t fall neatly into the framework of the capital asset pricing model (CAPM), and cannot be fully described through their correlations with the S&P 500. I guess, that’s why they are labeled “alternative” investments.

In my mind, the word “alternative” is not that far from “marginal”, and in real life it seems like many people tend to marginalize these investment options. I don’t know why… Perhaps, it is fear of the unknown, as many “alternative” investment strategies may not be easy to comprehend within the modern seven-minute attention span…